Tuesday, November 30, 2010

Imagine for a moment that the designers of the various investment risk measures have gathered for a dinner; perhaps this is an annual event (may as well have it annual, since we like to annualize risk measures, right?). And imagine that you have the opportunity to witness what occurs; perhaps someone videotaped it and placed it on YouTube for all of us to view. We find Bill Sharpe (Sharpe ratio), Leah & Franco Modigliani (M-squared), Jack Treynor (Treynor ratio), Brian Rom (Sortino Ratio), Michael Jensen (Jensen's alpha), Fischer Black (who, along with Jack Treynor, came up with the Information Ratio), and others.

During the pre-dinner cocktail hour a debate ensues, as one after the other guests begins to argue that their formula is the most appropriate to measure and evaluate investment risk. Suddenly, Sir Francis Galton, at 188 years of age, slowly rises from a chair and boldly proclaims that it's quite evident that his is the far superior measure, and he can prove it! After all, his and his alone has been "endorsed" by GIPS(R) (Global Investment Performance Standards). And what, pray tell, is his measure? Well, if the name Francis Galton is unfamiliar to you, his measure surely isn't: standard deviation.

With the 2010 version of the standards all compliant firms must include the three-year annualized standard deviation; what further proof is needed to elevate his metric above the rest. And even if a compliant firm argues that this measure is inadequate for their strategy, they must still show it, along with an explanation as to why it isn't effective and the measure they feel is.

Well, I remain unconvinced, and will (hopefully) soon pen an article that will address this measure's weaknesses at great length (sorry, Frank!).

p.s.,With all due respect to Sir Francis, even the GIPS EC would, I believe, gladly explain that its adoption of standard deviation falls well short of an endorsement for it being numero uno when it comes to risk measures. A recommendation to include a risk measure has been part of the standards since its introduction, and the EC took it upon itself to identify a measure to be used across the board. They, no doubt, recognize many of its shortcomings but also recognize that its an easy measure to calculate and is, in reality, used by most asset managers (as shown in surveys that our firm has conducted). And so, please accept this blog's boldness (and Sir Francis' claims) as a bit of hyperbole.

Monday, November 29, 2010

While "risk" seems to be a more commonly found topic in the Wall Street Journal, I was pleased to see this advertisement appear in this past weekend's edition. First, it's wonderful to see a focus on diplomas, especially for inter-city children; as a former "inter-city" child myself (though we didn't use the term in the '50s and '60s), I have an appreciation for such achievements.

What strikes me about this ad is the personalization of the return; something we've been trying to get folks to identify with for some time. Again, it has to do with perspective. Returns often are multidimensional, and to solely view them through the lens of time-weighting does them an injustice. Perhaps this piece can serve to wake more folks up to the importance of money-weighting.

p.s., we hope you'll consider donating to this worthy cause. Go here for the full size ad and details on how to contribute.

Sunday, November 28, 2010

Jason Zweig's piece in this weekend's Wall Street Journal serves many purposes, one being a clue as to why it's so difficult to beat indexes. It occurred to me some time ago that the index designers must be exceptionally talented at constructing them, but perhaps their mere existence serves as a device for "above average" performance, since any changes to them typically result in buying frenzies which, of course, cause stock prices to rise (and of course selling of the tossed out issues).

There is probably plenty of room for research into this phenomenon, and perhaps much has already been done (I haven't yet investigated this). But Jason's insights offer, as usual, good reading material and ideas to ponder.

Monday, November 22, 2010

We often get contacted by hedge funds who are considering GIPS(R) (Global Investment Performance Standards) compliance. For some reason they see this as being a monumental task; but it really isn't. Here are some key attributes of hedge funds which make the task a lot easier for them than long-only managers:

Hedge funds typically establish separate partnerships by strategy, so they're normally looking at a one-to-one relationship between funds and composites. In other words each composite will likely have only one (or only a few at most) fund(s). Meaning the composite is the fund's return, the composite's assets are the fund's assets, and there is no measure of dispersion.

Hedge funds typically limit cash flows to once a month, normally at the end of each month. This means that the funds are valued at month-end before the flows are applied. Therefore, their returns are usually pretty simple to deal with. And, they automatically meet GIPS requirements.

A hedge fund manager's policies will no doubt be easier to implement than for a long-only manager who is more likely dealing with a lot more diverse accounts.

While it's true that in the institutional, long-only space, one can no longer claim a "marketing advantage" by complying, because virtually all of the firm's peers already comply, this isn't true in the world of hedge funds. Here there is clearly an advantage to make the effort. The investment to comply isn't going to be as great as you'd think, so why not make it?

Friday, November 19, 2010

I got a call from another verifier who was wondering if GIPS(R) (Global Investment Performance Standards) 2010 requires firms that object to the use of annualized standard deviation to still show this measure, even though they have (a) documented why standard deviation doesn't apply and (b) provided a substitute. And the answer is (drum roll, please)....yes.

I objected to this new requirement, as did many others who commented on the "exposure draft," but it remained. In addition, it requires firms that feel that standard deviation is a poor risk measure to employ for their composite's strategy to explain why and provide the measure they feel IS appropriate; but it STILL requires firms to show the three-year annualized standard deviation.

Wednesday, November 17, 2010

I'm teaching our Fundamentals of Performance Measurement course for a client this week and have been asked some interesting questions by the students. One asked why we multiply returns in order to link them. Questions like this require, I believe, a bit of detail in their response, so let's discuss it here.

Let's say that our first quarter returns are as follows:

The rule we apply to compound is to add one to each return, multiply them together, and then subtract one, which results in:

But why? Why is this the right return? And again, why do we multiply?

Well, we are multiplying in order to compound our returns. January sees a return of 10%, which adds 10,000 to the account's market value. February's return is applied to both the starting or base amount (100,000) as well as January's gain (10,000), and March's return goes against the base, January's gain, as well as February's (5,500). This might help:

Questions like the one this student posed requires some thought, and I believe I've represented what happens, though will expand upon this further in our December newsletter.

Tuesday, November 16, 2010

Does it really mean a lot if someone has a string of letters after their name, such as PhD, CFA, CIPM, CPA, CAIA, FRM,...?

Well, I strongly believe that the answer is "yes"!

First, each set of letters represents an achievement. They indicate that the individual had to do something in order to be awarded the letters.

Second, they bring attention to the organization(s) that bestow the letters and the industry for which the letters are linked.

Take, for example, the CIPM: Certificate in Investment Performance Measurement. They let us know that the individual has achieved a certain breadth of knowledge in the field of investment performance measurement. But in addition, they indicate that the field is one that is worthy of recognition itself. Performance measurement is a profession in which many very talented individuals have decided to invest their time and energy; why shouldn't they and the industry they serve get this recognition?

I'm a bit surprised by the number of investment performance measurement professionals who haven't yet pursued the CIPM certification. Granted some might say "well, I've been in the industry for 20 years so I don't need the certificate," which is definitely a truism. My friend Carl Bacon could have easily said this as Carl has achieved quite a degree of notoriety over the years, most of which is well deserved ... (sorry; just kidding! all is well deserved). But Carl decided to pursue the certificate in the very first "class." And why? I believe to honor the profession and the program. Others such as Neil Riddles and Douglas Lempereur did this, too, even though each of them is a CFA charter holder. The latter two, I believe, add credibility to the notion that simply because you have the CFA (as if obtaining it is "simple") doesn't mean you have achieved the breadth of knowledge about investment performance which the CIPM program tests you for.

If you're fairly new to the world of investment performance, you should pursue the CIPM certification in order to gain the knowledge and hopefully designation which will indicate to others what you've accomplished. And if you've "been at this game" for some time and believe your years speak for themselves, then I encourage you to still pursue the CIPM, if not for you then for the industry.

I occasionally hear folks say "well, the CIPM program hasn't yet caught on so why bother." Well, of course it won't "catch on" until folks like them DO bother. So make the investment: in yourself and in the industry!

Wednesday, November 10, 2010

Often when meeting with clients or teaching a class on the Global Investment Performance Standards (GIPS(R)), I mention the basic requirement that all actual, fee paying, discretionary accounts must be included in at least one composite. But what do these words mean? They can be confusing, so let's briefly touch on them:

Actual: a REAL account; i.e., not a model account, the results of back-testing, or a hypothetical account. You ARE permitted to show the results of model, back-tested, and hypothetical accounts as supplemental information, but their results cannot be linked to those of an actual account and they aren't to be included in composites.

Fee paying: the client pays an advisory fee for the investment services. Granted, you can include non-fee paying accounts in composites, too, but additional disclosures are needed if you do this.

Discretionary: this is the most challenging word. We're not talking legal discretion, but rather the ability for the manager to execute their strategy. That is, if a client has imposed restrictions will their results be representative of the composite's style? If yes, then it's fine to include them; if no, then the firm should have a policy that would exclude them.

Tuesday, November 9, 2010

We were recently asked by a client to come up with a list of current trends in performance measurement. In collaboration with my colleague John Simpson we propose the following:

1. GIPS 2010(R)
2. We are seeing non-traditional sectors (alternative asset classes, such as real estate, private equity, and others, along with hedge funds) showing interest in GIPS.
3. We also see increased interest in the retail market for GIPS compliance.
4. GIPS verifications are definitely up; don’t know if this is a result of Bernie Madoff, the market downturn, or both or something else, but we get inquiries from lots of firms who want to get verified; in some cases these are firms who have been claiming compliance for some time, while in other cases they’re firms who are also wanting to become compliant with the standards
5. Money-weighting (granted, WE do a lot of talking on this subject, but many of our clients, too, find it of value)
6. We are seeing some interest in reviewing report packages, to ensure that what is provided is appropriate; either us do the review of they do a self-review; some of this translates into report design, as you would expect.
7. There seems to be some interest in reporting standards, though I think reporting guidelines would be better and I think this is what most folks really mean
8. Ex ante (forward looking) risk
9. Data quality; is the data scrubbing sufficient? this also includes validation, to some extent, of the indices.
10. We continue to see interest in fixed income attribution
11. CIPM Program
12. Balanced portfolio attribution.

Wednesday, November 3, 2010

Earlier this week I posted on calculating returns for employee stock purchases and promised that this would be addressed at length in this month's newsletter. Well, our friend (and frequent commenter to this blog) sent me a note, which I want to share with you:

Dave:

I really don’t get your case study on linking and annualizing returns. Take a look at my attached spreadsheet which illustrates my understanding of your scenario. Here are my issues:

1.You are compounding returns that are instantaneously granted through the discount stock purchase program. But, this is a one-time granted return and it only affects the initial purchase amount. It does not compound against the purchases previously made.

2.You assume there is no price appreciation over the purchase period, so what is there to compound? There are no market returns that affect the prior invested amounts.

a.I added a column that randomly generates returns within +/- 10% per quarter. However, you can overlay this with zero returns if you wish.

3.I treat the initial purchase as something that grows instantaneously at the beginning of the period, and then at the end of the period the additional amount is added. This allows the initial purchase to get the discount adjustment gain, and then be subject to market price change. Again, the market change can be switched off.

4.I calculate a simple gain against the average invested amount (it’s like a Dietz return) and it equals the 60% you state in your question. It’s a reasonable and intuitive measure of value gained from the discount program.

5.I also calculate an IRR that is “annualized” although I don’t think that either compounding or simply multiplying are perfect. You’ll note that neither of these are close to your compounded value of near 75%. Again, I think your error is because you are continuing to compound the original 15% gained at purchase against the entire accumulating amount. This is wrong, as the discount only applies to a single purchase. That said, there really is no compounding here. The mechanics have gotten ahead of the question and the investment scenario.

I don't know how to attach a spreadsheet to a post (or even if this is possible), so if you want to see Steve's spreadsheet, send me a note and I'll pass it to you.

I greatly appreciate Steve taking the time to chime in, and have no disagreements with his arguments.

Tuesday, November 2, 2010

We were on the phone today with a small hedge fund manager who wishes to comply with the Global Investment Performance Standards (GIPS(R)). First, we think this is GREAT, since there is clearly a trend in this segment of the market to achieve compliance. BUT, there is a lot of confusion here, beginning with how hard can it be? Well, it aint that hard...for a hedge fund manager, that is.

Recall that the standards require that all actual, fee-paying, discretionary accounts to be in at least one composite. Okay, great. And what does that mean in the world of hedge funds?

Well, since most hedge funds managers manage a limited number of funds, where each is distinct from the others, we're usually talking a one-to-one relationship; that is, one fund = one composite. And so,

the return of the fund equals the return of the composite.

the fund assets are the composite's assets

there is no measure of dispersion

and since most hedge funds limit cash flows to once a quarter or once a month, the returns are fairly easy to calculate.

So, the work shouldn't be too complex.

This doesn't mean there aren't issues (such as how do you deal with side pockets and how to value certain assets), but it's definitely not as challenging as it is with most long-only managers.

If you know of a hedge fund manager that wants to comply but can use help, please point them our way! They can call (732-873-5700) or e-mail (CSpaulding@SpauldingGrp.com) Chris Spaulding for more details.

Monday, November 1, 2010

I am very pleased to announce that the NYSSA has published a brief article of mine on the Pitfalls of Value at Risk. I had written an earlier background piece on VaR for their journal, so this can be viewed as a follow-up piece. Hope you have the chance to review it, and please let me know your thoughts.

I got an e-mail question on Friday with the following request: We have a discount stock plan at our firm. You can buy discounted stock at the end of each quarter and can sell it immediately for a 15% profit. The question arises about what your annual return would be.

"Many of my colleagues argue that 15% a quarter sums to 60% annually (ignoring geometric linking which cannot apply since there is no compounding). I have a problem with this because the money invested is four distinct unrelated transactions and if you divide the total gain by the sum invested you would get 15%"

When I first considered this problem I focused only on a single execution, to determine the annual equivalent (recognizing that it's generally inappropriate to annualize for periods less than a year). If we treat this as an event for a quarter, then the process is pretty simple:

Add 1 to the return (1.15)

Raise it to the inverse of the period expressed in years (1/0.25)

Subtract 1.

And our answer: 74.90 percent. This is the annual equivalent of that single quarterly event.

If the ability to generate a return quarterly is 15%, then we could geometrically link four quarterly returns of 15% each:

Add 1 to each return (1.15)

Multiply them together

Subtract 1.

And we get ... 74.90 percent return!

p.s., The same day I got this e-mail and did the analysis, a technician came to my home to winterize the sprinkler system. The cost for the service? $74.90. Kind of weird, right?

p.p.s., If you think this is the last word on this subject, you'll be pleased to learn that we will address this at much greater length in the November newsletter. As you'll see, depending on one's perspective, we can get different answers!

Spaulding, David Spaulding

About David Spaulding

is an internationally recognized authority on investment performance measurement. He's the founder and Chief Executive Officer of The Spaulding Group, Inc. (www.SpauldingGrp.com), and founder and publisher of The Journal of Performance Measurement. He's the author, contributing author, and co-editor of several investment books. He's actively involved in the investment performance industry, serving on numerous committees and working groups.
Dave earned his BA in Mathematics from Temple University, his MS in Systems Management from the University of Southern California, an MBA in Finance from the University of Baltimore, and a doctorate in Finance and International Economics from Pace University.
For more information please visit www.spauldinggrp.com/the-company/david-spaulding.html

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